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Interview With Steve Keen: It's All About the Debt

Nov. 9, 2010 5:13 AM ETby: Chris Martenson

"Straight Talk" features thinking from notable minds the ChrisMartenson.com audience has indicated it wants to learn more about. Readers submit the questions they want addressed and our guests take their best crack at answering.

This week's Straight Talk contributor is Steve Keen, Associate Professor of Economics & Finance at the University of Western Sydney, and author of the popular book Debunking Economics and the website Steve Keen's Debtwatch. Steve's research focuses on the dynamics of debt and leads him to believe that debt-deflation is the key issue that will continue to dictate what happens in the global economy.

1. Much of your research is complex. Can you summarize some of the more important conclusions of your work in ‘layman's’ terms for us?

Steve: Sure. My work is complex in part because I reject conventional economic analysis, which has infected how ordinary people think about the world—just as the Ptolemaic view of astronomy infected people’s minds prior to the Copernican revolution. So to explain my work I have to start with where I differ from conventional “neoclassical” economists, who now are rather like Ptolemaic astronomers—who tried to understand what they see in the sky by inventing more and more “spheres” on which heavenly bodies were supposed to rotate, rather than accepting Copernicus’ far simpler model of a solar system centered on the Sun.

The key ways are that I see the economy as being credit-driven, and out of equilibrium all the time. The economy needs an expanding supply of money to grow, and in our credit-driven economy, most of that expansion is driven by rising debt.

This isn’t necessarily a bad thing: an entrepreneur with a good idea needs money to put that idea into action, but hasn’t necessarily got the money to finance it. Debt as a form of venture capital gives him that money, which therefore means he has money to spend before he has goods to sell to finance that expenditure. As a result, aggregate demand in the economy exceeds the level it would be if it was financed simply by selling existing goods and services.

This is a good thing, since otherwise innovation and growth wouldn’t necessarily occur, but it also brings a danger that debt can be used, not merely to fund entrepreneurial activity (which is a good thing), but speculation on asset prices.

It also introduces a volatile term into aggregate demand that almost all other economists—neoclassical, so-called Keynesian and even Austrian economists—ignore: aggregate demand in the economy is the sum of GDP plus the change in debt, where that aggregate demand is spent not merely on new output (goods and services) but also on purchases of existing assets (shares and property).[1]

Economic activity—and hence employment—is thus determined not merely by the level of production and incomes, but also by changes in the level of debt. This generates credit-driven cycles that can occur even if debt is still growing, simply if the rate of growth of debt alters. It can also generate long false booms, if the rate of growth of debt continually outstrips the rate of growth of the economy, and especially if that debt financed not entrepreneurial innovation, but gambling on asset prices.

That’s been the story of the last 40 years for America and much of the OECD: debt has grown faster than GDP, and much of the debt has financed speculation rather than investment. The growth in debt during the long boom stimulated demand, but it didn’t add to productive capacity. So when the rate of growth of debt stopped, the debt burden was much higher than it had ever been before.

The only way to restart growth as we had known it for the last 4 decades was for debt to start growing faster than GDP once more. My belief that we’d reached the end-point of this process—that debt to income ratios had reached a limit—is why in late 2005 I predicted that there would be a serious Depression-level crisis in the near future.

Imagine a country with a nominal GDP of $1,000 billion, which is growing at 10 per cent per annum (real output is growing at 4 per cent p.a. and inflation is 6 per cent p.a.), and which has an aggregate private debt level of $1,250 billion which is growing at 20 per cent p.a.—so that private debt increases by $250 billion that year.

Ignoring for the moment the contribution from government deficit spending, total spending in that economy for that year—on all markets, both commodities and assets—is therefore $1,250 billion. 80 per cent of this is financed by incomes (GDP) and 20 per cent is financed by increased debt.

One year later, the GDP has grown by 10 per cent to $1,100 billion, but imagine that debt stabilizes at $1,500 billion, so that the change in debt that year is zero. Then total spending in the economy is $1,100 billion, consisting of $1.1 trillion of income-financed spending and no debt-financed spending; this is $150 billion less than the previous year. Stabilization of debt levels thus causes a 12 per cent fall in nominal aggregate demand.

What about if debt doesn't actually stabilize, but instead grows at the same rate as GDP? Then we get the following situation: in the first year, total demand is $1,250 billion, consisting of $1,000 billion in income and $250 billion in increased debt; in the second year, total demand is also $1,250 billion, consisting of $1,100 billion in income and $150 billion in increased debt. Nominal aggregate demand is therefore constant, but after inflation, real aggregate demand has contracted by 6 per cent.

There are thus three ways in which debt affects economic activity: by its level, its growth rate, and whether its growth rate is rising or falling. As this numerical example illustrates, the economy can suffer a recession simply if the rate of growth of debt slows down—absolute deleveraging isn’t required to have a recession, but deleveraging is what turns a garden variety recession into a Depression.

These three factors—the level, rate of change, and acceleration rate of debt—are easily shown to be the driving forces in “The Great Recession”. They’re shown together on the chart below (the graphs don’t quite line up because the velocity and acceleration are measured with a one year lag):

click to enlarge

Think about them in terms of driving, where distance, velocity and acceleration determine how the journey will go.

The level is like distance: the further apart two places are, the longer the journey will be at any given speed. A small debt to GDP ratio is like a short drive—you rarely worry about it—but a large ratio is like a very long drive. In that sense, America has a long way to go to get back to where it was before growth in the shadow banking system turned its economy into a disguised Ponzi Scheme. Debt would have to be reduced by the equivalent of two full years of present-day GDP. That’s an enormous amount of deleveraging.

The rate of change is like velocity: it tells you how fast you’re travelling towards your destination, and the impact of that velocity on the economy is a bit like the thrill of driving quickly versus moving slowly. The velocity of the USA’s increase in debt was rising right from the end of WWII till the end of 2006. When it was fast, it felt like racing between cities—and unemployment fell as a result. When it was slow, it felt like being stuck in an LA traffic jam—and unemployment rose. Now that it’s negative (for the first time since the Great Depression) it feels like you’re rolling backwards very quickly—and unemployment has exploded.

However unemployment has stabilized recently because of the third aspect of debt: its acceleration, which is like acceleration in driving speed too: put your foot down and you’ll feel the pleasurable G-forces from moving more quickly; slam on the brakes and you’re body will push against the constraints of the seat belt (if you’re wearing one).

The trick here is that, since aggregate demand is the sum of GDP plus the change in debt, the change in aggregate demand is the sum of the change in GDP plus the acceleration in debt. Since the change in aggregate demand determines the change in employment, it’s possible for employment to get a boost merely if the rate of deleveraging declines: so reducing debt more slowly will actually stimulate demand.

This is what has happened recently, as my next chart shows (again with a lag since I’m graphing the acceleration in debt from a year ago against unemployment now). Because the rate of deleveraging has slowed down recently—and largely under the impact of government policy which is trying to encourage lending (as well as undertaking its own public-debt-financed spending)—that feeling of rolling backwards is slowing down and making us panic less.

However, there’s a limit to this feel-good factor: for the deceleration in deleveraging to continue, at some point America would need to start re-leveraging again—to increase debt faster than GDP once more. That was feasible when debt levels were smaller—like back in the 1970s when debt first exceeded 100% of GDP. Now that it’s almost 300%, all sectors of the economy are “maxed out” and it’s highly unlikely that any can be enticed into increasing their leverage.

The days of the Ponzi Economy are finally over. The only sector of the economy which now has the capacity to expand its debt level is the government, which brings me to your next question.

2. Your position is that deflation is the more likely outcome for major global economies because the amount of private debt that needs to be written-off/deleveraged dwarfs any money-printing central banks will be able to do. True? And if so, how do you see things playing out from here?

Steve: Yes that’s true, but I have to admit that the scale of government spending to fight this crisis—as well as the willingness of politicians to restart some of the irresponsible private sector behaviors that caused the crisis in the first place—took me by surprise.

On reflection, I shouldn’t have been so surprised, because politicians and their conventional “neoclassical” economic advisers were rather like the captain and crew of the Titanic, confidently driving the ship full throttle in the belief that there weren’t any icebergs in the North Atlantic. When they finally saw one, they went from confident complacency to sheer panic, and threw every economic principle that they had previously sworn by out the proverbial window.

Ironically, those “principles” told them that fiscal policy couldn’t boost aggregate demand, and that the economy could be fine-tuned by small adjustments to interest rates. But in panic they hit their economies with the biggest fiscal stimuli in human history, and drove interest rates as low as they could go.

The outcome is that they have managed to slow down the rate of deleveraging compared to what it would have been without their interventions—and this has stabilized the downturn to some degree in the USA.

However the rate of private sector deleveraging—particularly by the shadow banking sector, which was largely responsible for the crisis in the first place—has still been so great that government action hasn’t prevented deleveraging, even when government debt-financed spending is taken into account. But the government’s policies have managed to slow down the rate of deleveraging, and this is what has temporarily stabilized unemployment.

If governments kept this level of spending up, then they could possibly cause an outcome like Japan since its Bubble Economy burst back in 1990: where rising levels of government debt neutralized the depressing impact of excessive private debt. This would imply a sustained period of stagnation rather than growth, and I don’t think this would be politically sustainable in the West.

However what’s more likely now is a return to the previous ideology that governments should at worst balance their budgets, and preferably run surpluses—this is certainly the bias in the UK’s recent political shift, as well as in the recent Republican revival in the USA. These policies would withdraw publicly financed spending power from their economies without enabling its replacement by private credit financed spending. Private sector deleveraging would restart and we would fall back into recession/Depression.

This will cause a rise in unemployment again, and strong political fallout this time too since incumbent politicians would be directly responsible for it. I would expect a renewal of the stock market falls of 2008 if this happened, and a renewal of the gold bubble.

The one country that has apparently avoided the crisis so far is my home country, Australia. This isn’t because it behaved differently prior to the crisis, but because government policy halted private sector deleveraging in late 2009, and since then private debt has grown and continued to boost aggregate demand.

Thanks to this—and Australia’s favorable position relative to China—Australia’s unemployment level peaked at 5.8% and has since fallen to 5.1%--virtually half the US rate.

The only reason that Australia succeeded in stopping deleveraging was that it encouraged the household sector back into speculating on house prices via what it called the “First Home Owners Boost”—in which an already generous A$7,000 government subsidy to first home buyers was doubled (and trebled for those buying newly built homes). If they hadn’t done this, then Australia would have experienced deleveraging as did the USA, and its unemployment rate would be substantially higher than it is now, because aggregate demand in Australia would have been about $100 billion lower.

The roughly A$4 billion that the government threw into the scheme was turned into about $100 billion of extra borrowed money in the economy via a double-leverage process: first home buyers used leverage from the banks to pay an additional (say) $40,000 for their first purchase; the vendor then took the additional $40,000 and levered that up to an additional $200,000 (say) on their next purchase.

The end result was that mortgage debt, which was on track to fall to about 79% of GDP by mid-2010, instead rose to 87%--an 8% turnaround in debt-financed spending.

This renewed the speculative bubble that had already made Australian house prices the most unaffordable in the world.

But hey, why complain about a Ponzi Scheme when it gives you a booming economy? Governments around the world are now trying to restart the private lending engine that had caused the crisis in the first place by financing disguised Ponzi Schemes in shares and property.

Finally, there should be no mistaking that the USA is in a Depression. While the headline U-3 unemployment rate is a “mere” 9.6%, the more realistic U-6 rate is 17%, and Shadowstats alleges that the real rate is 22.5% (though John Williams notes that the comparable rate in the Great Depression would have been 37%—so U-6 is therefore probably a comparable measure to unemployment in the 1930s). Either of the last two rates is clearly in Depression territory.

The level of private debt is 1.7 times what it was back in the 1930s, which implies that the deleveraging pressure will last much longer than it did back then; on the other hand, the larger government sector and it rapid response to this crisis works in the opposite direction. This however implies a Japanese-like outcome: decades of sub-par growth. I expect instead that the other major forces of our time—Peak Oil and Global Warming—will kick in and force significant changes in human behavior long before the politicians confront the financial sector.

3. What is your rebuttal to the (hyper) inflationists? What data would you need to see to reconsider your position? Does the recent news and market reaction to QE2 affirm or challenge your position?

Steve: The hyper-inflationists basically argue that government money creation will cause hyper-inflation. In this I think they’re unwittingly relying on the “Money Multiplier” model of money creation: the government prints $10, a depositor puts this in a bank account, the bank hangs onto $1 and lends out the other $9, which is deposited in another bank, and so on. Over time you turn $1 of government money into $10 total, which drives up demand for goods and services and causes inflation.

The Central Banks themselves are relying on the same model—especially Bernanke with QE1 and now QE2. So if the model actually worked, both Central Banks and the hyper-inflationists would be right: inflation would result and our current debt-deflationary crisis would become an inflationary one. The only difference is that the Central Banks think they can control and moderate the rate of inflation, and the hyper-inflationists think it will be a runaway process.

The trouble is, as I showed in the “Roving Cavaliers of Credit” post, is that this “deposits create loans” model isn’t how credit money is actually created. Instead, as good empirical work by Basil Moore and other Post Keynesians (and even staunch neoclassicals like Kydland and Prescott) has confirmed, “loans create deposits”, and government money creation largely follows credit money creation, rather than the other way around.

Ironically, this fallacy gives the hyper-inflationists and the Central Bankers—in particular Bernanke—something in common: they both appear to believe that Central Banks can cause inflation easily, and that the Great Depression was the fault of the US Central Bank. Bernanke goes to great lengths to assert this in his Essays on the Great Depression, and even famously remarked to Milton Friedman and Anna Schwartz at Friedman’s 90th birthday party that:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

His main evidence was the collapse of M1 under the Fed in the 1930s, which he said turned a mild downturn into the Great Recession, and on Friedman’s data, this did indeed happen.

But if you take a look at the St Louis FRED series for M0, you can see that this collapse in M1 occurred even though the Fed at the time was boosting M0.

So Bernanke was wrong: the Fed did try to cause inflation during the Great Depression—it just didn’t work. M1 fell even though M0 increased because private sector deleveraging and the consequent reduction in the money supply swamped the Fed’s attempt to boost the money supply via increasing M0.

The upshot of this for the inflation-deflation debate is twofold. Firstly, an injection of government money will not cause a boost in credit money creation—especially in the world we live in now with such excessive levels of private debt. Secondly, Central Banks will underestimate the amount of money they need to inject to actually cause substantial inflation—and they’ll probably give it to the wrong groups as well (bankers rather than debtors) in the false belief that this will give them more “bang for their buck”.

These results are apparent in Bernanke’s first attempt to right the ship of state, QE1 (as it now has to be called) when he doubled base money in just 4 months. To give him some credit here, this was a far larger attempt to stop deflation than his predecessors attempted—and to more than take that credit away, he was also complicit in ignoring (and in fact promoting) a far larger runup in private debt prior to the crisis, which was the real cause of the Great Recession.

QE1 did cause some inflation, but very little compared to what I think Bernanke expected, and it’s already turned back towards deflation.

I also have my own dynamic modeling of inflation, which relates it to four factors: changes in money wages, the level that firms markup their monetary costs of production, the money stock and its rate of turnover. The hyper-inflationists focus only on the third issue—the money stock and in particular its rate of growth. During a Depression, falls in money wages, falls in firm markups, and a reduction in the rate of turnover of the money stock can easily counter growth in the money stock—especially when the privately created component of the money supply is also falling.

So it would take an enormous injection of base money to turn these other factors around. If Bernanke was contemplating not a mere $600 billion in QE2 but say $6 trillion in QE3, then I might expect deflation to give way to inflation. And if they gave the money in QE3 to the debtors rather than to the banks, then there would also be more inflation. But I think both those outcomes are highly unlikely.

4. Related to the forecast you provided in question 2, what should we (governments, corporations, individuals) be doing right now to restore fiscal “soundness”?

Steve: This is a tricky one for a very simple reason: if my preferred remedies were enacted now, they would be blamed for causing an ensuing crisis, when in fact all they would do is make the existing crisis more obvious.

I make the analogy between my situation and that of a doctor who has as a patient a comatose mountaineer who climbed too high without sufficient insulation and now has gangrene. If you operate before he regains consciousness, he might only lose a foot, but he’ll blame you for making him a cripple. If you wait till he regains consciousness and sees what the alternative might be, he’ll thank you for saving his life when you remove his leg.

America in particular—but also much of the OECD—has substituted essentially unproductive Ponzi speculation for real productivity growth in the last 4 decades, which the rising debt bubble has obscured as it simultaneously allowed Americans to live the high life by buying goods produced elsewhere using borrowed money. There’s no way to come to terms with that without suffering a substantial fall in actual incomes.

I’d prefer to come to terms with these realities rapidly rather than slowly, but the political reality is, as Winston Churchill once put it, that “The United States invariably does the right thing, after having exhausted every other alternative”. So I’m proposing changes that I know are only feasible after several more years of failed conventional policies have been tried. I also realize that most of these ideas are well outside not just the mainstream, but many of the positions put by non-mainstream critics as well.

The basic list is:

Abolish Ponzi debts, which are those that have been used primarily to drive up asset prices rather than finance investment or consumption. This includes most shadow banking system debt (about 100% of GDP), much of the runup in household debt since 1985 (when it was about 50% of GDP), and probably most of the 30% increase in business debt beyond the 50% level that applied in the 1970s.

Since the first move would bankrupt the financial sector (or rather convert it’s state of de facto bankruptcy after the crisis—without the government bailouts—into de jure bankruptcy) banks should be put into temporary nationally administered receivership, during which time the flow of working capital to firms would be maintained.

Reform financial assets to prevent future debt-funded Ponzi bubbles. As I explain in the Roving Cavaliers of Credit, I don’t think it’s possible to stop banks wanting to lend too much money, so I’d rather reduce the attractiveness of debt for Ponzi speculation itself by making it much less likely that profits could be made from leveraged speculation.

Finance infrastructural development with fiat-money financed government deficit spending as recommended by the American Monetary Institute. I don’t accept the position put by so-called Chartalist economists that government spending can overcome any recession, but we live in a mixed credit-fiat money economy, and just as private sector money should grow when the economy grows, so should fiat money. The failure of the government to do this under the influence of Friedmanite ideas about money was a contributing factor in the explosion of debt-financed money and the financial crisis. It caused a rundown in the quality of US infrastructure, and I defy anyone to argue that government spending could be any more wasteful than what the private sector did with its monetary growth. Especially in a period where private investment is likely to be subdued, there’s a good reason for government spending on infrastructure to lead the way to revived expectations.

5. You have a front row seat to the rise of the Asian economy from your home in Australia. If/when, the US defaults on its debt obligations (either through devaluation of the currency or pure default), what specific steps do you see China and Japan taking to protect their interests?

Steve: China is already doing it: China undertook a deliberate program of industrialization via the relocation of production by western multinational corporations from America (and elsewhere), and unlike much of the Third World, required these foreign companies to take on local partners and transfer ownership of much of the capital over time to Chinese nationals. So they won the War of Industrialization in the last 3 decades, while the West lost. That industrialization was primarily directed at export sales that were debt-financed; now that they are drying up, China is hanging on to the capital and expertise it has accumulated, and redirecting production as fast as it can towards domestic demand.

They are also moving out of the US dollar and US bonds into commodities, and trying to buy up direct ownership of resources worldwide with the US dollar purchasing power they accumulated via their trade surpluses. So by the time any default comes—or more likely before the devaluation of the US dollar becomes extreme—they will have transferred their monetary assets into real ones.

Japan is likely to be far less assertive in its moves. It’s likely to hang on to the bonds as the US dollar depreciates, though unwinding of private holdings of US financial assets is likely to amplify the downward trend in the dollar.

6. What are your views on peak oil? Specifically, when do you forecast the market will recognize its significance? What do you see as its impact on the economic growth of developing nations?

Steve: I regard Peak Oil and Global Warming as far greater challenges to our species than the financial crisis—which I refer to sometimes as Peak Debt. It amazes me that awareness of Peak Oil is as limited as it is, when the evidence is quite compelling and the basic concepts quite straightforward. The fact that the USA became besotted with SUVs during the SubPrime Boom is just another indicator of how lacking in foresight the human species seems to be—despite our incredible intelligence.

The financial market will likely react to it five or ten years after we’ve passed the Peak, and the physical market—the means of transportation we still buy, the way we generate energy—is over 30 years too late in reacting. We should have developed transportation systems like the SkyTran magnetic levitation grid a decade or more ago.

7. Assume you were not an exceptionally wealthy person, and you couldn’t move from America. What specific steps would you take to protect yourself physically & financially?

Steve: There’s not much that a not exceptionally wealthy person can do individually. Wealthy individuals can buy commodities like gold and preserve their wealth if they gamble correctly; poor individuals aren’t likely to secure a future for themselves that way because they could never generate the income flow they’d need from investments in such resources with meager finances.

I think it’s wiser to stop thinking individually about this and consider political change—a thinking person’s Tea Party perhaps. We need social reforms so that bankers and the financial sector cop the pain of the adjustment, whereas at the moment the pain is all going the way of the poor and marginalized.

8. Which current economic writers/market commentators do you follow and why, even if you do not necessarily agree with them?

Steve: I don’t get much time to follow market commentators—I’m too overloaded with my own research and teaching commitments—but those I do occasionally read and always recommend include Mish, Michael Hudson, Yves Smith, and Doug Noland. My economic readings are eclectic: few of the modern writers interest me outside the Post-Keynesian sphere, and even there I am somewhat of a critic of a lack of analytic rigor; instead I read work by complexity theorists. Of the past authors, Schumpeter, Fisher and a very non-orthodox reading of Marx (modern-day Marxists dislike me almost as much as neoclassicals do) are the major interests.

9. You’re a researcher: which projects are you working on now that interest you most?

Steve: On April 16 1999, I signed a contract with Edward Elgar Publishers to publish a book based on my PhD thesis on modeling Minsky’s “Financial Instability Hypothesis”. I had hoped to complete it in 2001, but took six months out to write Debunking Economics instead.

Eighteen months later I finished Debunking Economics, and five years later I finished the argument that it provoked with neoclassical economists. I then planned to started work on Finance and Economic Breakdown in December 2005, checked the figures on Australia’s and the USA’s debt levels while drafting an Expert Witness report for a court case on predatory lending—and realized that rather writing about how financial crises occur, I had to warn that one was imminent. So I started Debtwatch, and here I am five years later.

Finally, now that the crisis is a permanent fixture, it’s time to return to explaining how such crises happen in a book length treatment that covers sound economic theory—based primarily on the work of Hyman Minsky—dynamic modeling techniques and endogenous money theory. So that’s what I’ll be working on from January.

I’m also working with programmers to develop some new methods for dynamic modeling that might wean economists away from their outdated obsession with static modeling. The first instance of this is the program QED, which is freely available on my blog. It is still in the developmental phase, but I hope that it’s easy enough to use and appealing enough to the computer game generation to make neoclassical general equilibrium modeling look old hat.

I’m also working on a second edition of Debunking Economics for Zed Books. The book has been very successful—it has sold around 20,000 copies so far and is still selling a decade after its publication—and since I wrote it because I expected that a financial crisis was imminent, it’s time to update it now that one is well and truly with us.

10. What question didn’t we ask, but should have? What’s your answer?

Steve: The real question is not why I saw the crisis coming, but why the vast majority of economists didn’t. The reason is that they believe a theory of economics that is fundamentally unsound but incredibly appealing all at once—neoclassical economics. It sees itself as a fan of and defender of free market capitalism, but because it is so delusional it is more dangerous to capitalism than any number of left wing revolutionaries.

If we’re to avoid repeating crises like this, we have to acknowledge that we need a realistic theory of capitalism, rather than one that pretends it’s perfect. There may be more to be gained for capitalism’s benefit by reading the work of its critics—up to and including Marx, though I’m also a critic of simplistic Marxist theory—than from reading its fans like Milton Friedman. We need a realistic economics, not one that is ideological.

[1] This credit-driven perspective means that many of the concepts that conventional economists use are wrong: concepts like Walras’ Law for neoclassical economists, Say’s Law for Austrian economists, and even the “aggregate demand equals aggregate supply” analysis of so-called Keynesian economists (most of whom, including Krugman and Stiglitz, apply a caricature of Keynes’s original ideas) only apply in an economy in equilibrium and without credit. They are inapplicable to the real world.

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